Question

1. “Real options” use the concept of an option as the right but not the obligation to buy or sell an asset. In looking at investment projects with large capital expenditures – such as whether to drill for oil in a new field – managers often use this approach to planning their investment spending in stages. How would this approach be used to manage the risks in a large project, and why is it preferable to the use of discounted cash flows when setting up a capital budget?

Answer 1

Real options in capital budgeting enables the managers to react to uncertainities in the future. Through these options they can increase, reduce or postpone their investment and exercise the right as the future circumstances. The various types of real options are, the list is exhaustive, hence mentioning most common ones :

1. Option to defer the investment for example in case of an oil filed extraction the company may choose to wait till the business environment becomes more favorable i.e. increase in oil prices.

2. Option to reduce or contract business: This implies reduction in variable costs for the ongoing project or dropping the idea of expanding the project. For example, construction of a new oil field or plant.

3 Option to develop or expand : This involves expanding the ongoing project to a bigger scale if there is conducive business environment.

4. Option to abandon : The manager can abandon or levae the project any time by selling it off.

Discounted cash flows are used when setting up capital budgets is to reflect the time value of money since the worth of future cash flows is to be determined in dollar worth today.